Earnings indigestion could stall rally
Investors have hit the pause button, but a market pullback was long overdue. Wall Street will need evidence of decent profits to get stocks back on track.
NEW YORK (CNNMoney.com) -- The stock market rally has stalled in June. And that has to make you wonder if this is just a healthy pause after a three-month long surge -- or the beginning of another brutal leg down like we had last summer.
It hopefully is the former. After all, it does seem as if troubled financials such as AIG (AIG, Fortune 500), Citigroup (C, Fortune 500) and Hartford Financial Services (HIG, Fortune 500) are on more solid footing now than they were in early March.
But they're not exactly healthy yet either. So following a stretch in which the Hartford's shares tripled and AIG's and Citigroup's stocks quadrupled -- all from admittedly low bases -- it's not surprising that shares for these three have pulled back this month.
"At the March lows, we were on the precipice about to jump off. So it's a natural reaction to pause, and is not reason for more doom and gloom," said Richard Hughes, co-president of Portfolio Management Consultants, an investment firm with $7.5 billion in assets under management.
Other "hot" stocks of the spring awakening rally have also cooled off so far in June. Several retailers, such as Gap (GPS, Fortune 500) and Abercrombie & Fitch (ANF), are down after enjoying a nice pop from March through May.
Simply put, investors might finally be coming to grips with the notion that the economy may take more time to bounce back than originally thought. With the unemployment rate still rising, it's hard to imagine a quick recovery.
That's not necessarily a bad thing though. If anything, it's encouraging that investors finally seem to be paying attention to reality.
"During the rally, 'less bad' news was being interpreted as good. Now, less bad news is being interpreted as still bad," Hughes said. "That's healthy. People are not looking at things with rose-colored glasses any more."
Talkback: Is the recent market slump a healthy pullback or signs of more bad economic news to come? Leave your comments at the bottom of this story.
That could also mean that some of the recent fears about the Federal Reserve fanning inflation flames by keeping rates artificially low may be premature.
"The market was worried that the Fed was not going to take away the punch bowl before the party was over and that ignited inflation concerns," said Roger Bayston, a portfolio manager in the fixed income group at money manager Franklin Templeton Investments. "But it may be dawning on people that are not enough people at the party yet to drink from the punch bowl."
Along those lines, investors appear to be regaining their appetite for bonds and other less-risky investments in recent days.
The price of the 10-year Treasury note has edged higher, pushing the yield down to about 3.62%. Bond prices and rates move in opposite directions, and the yield on the 10-year flirted with 4% last week.
And the utility sector, which lagged while banks, retailers and tech stocks soared, is one of the few sectors that are up so far in June.
Utility stocks, in addition to being less cyclical, also tend to pay solid dividends. That makes them, much like bonds, attractive to more conservative investors who seek steady income streams.
"Across the board, what you are seeing is a return to investors looking at strategies to lower volatility," Bayston said. "Over long periods of time, fixed-income investments offer that."
It's also worth noting that even though this month hasn't exactly been a slow one for financial news -- with the bankruptcy of GM (GMGMQ), oil prices and gas prices rising, and regulatory reform all serving as juicy headlines -- June is still usually a bit of a snooze compared to July.
Next month, investors will have tons of quarterly corporate results to digest. These reports, most notably the guidance companies provide for the third quarter and remainder of the year, will give investors even more concrete clues about just how quickly the economy is recovering.
Are corporations feeling more confident about how they'll do in the second half of 2009? That's crucial information even if you are not an active investor. The faster that companies big and small begin to think that their sales and profits are about to turn for the better, the more likely they will be to start producing more goods and hire again.
But unfortunately during the rally, investors had been conveniently ignoring the fact that, even if the economy is starting to bottom out, profits are likely to remain weak for sometime. FedEx served as a sobering reminder of that Wednesday morning.
FedEx warned that earnings for its fiscal first quarter, which ends in August, will be in a range of 30 cents to 45 cents a share, substantially lower than the 68 cents per share analysts were forecasting. And it's not just a matter of FedEx (FDX, Fortune 500) missing expectations. The company reported a profit of $1.23 in the same period a year ago.
FedEx probably won't be an anomaly. Hughes said investors should not expect healthy profits from many companies for awhile, given that consumers, faced with a backdrop of rising unemployment and higher gas prices, are still wary.
"The cold reality of the economic situation is setting in. Earnings growth is going to be muted for the foreseeable future. Economic headwinds will make the results tepid at best," he said. "Much of the rally has been momentum driven and we'd like to see the fundamentals catch up."
Ron Sweet, vice president of equity investments with USAA, a money management firm in San Antonio, added that there is only so much more that companies can do with cost-cutting to bolster profit margins. So he's concerned that the market has rallied too sharply in too short a period of time.
"Nobody knows what the new normal for earnings will be. There is still lots of uncertainty," Sweet said. "There comes a time when earnings have to be driven by top-line growth and people may not be factoring that in just yet. Where are sales going to come from? You are eventually going to need real demand."
Talkback: Is the recent market slump a healthy pullback or signs of more bad economic news to come? 
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